The liquidity of a financial instrument is often overlooked, as investors strive to produce the best risk adjusted returns. Market liquidity usually fluctuates, but can be extremely illiquid as investors rush toward the exits during adverse market conditions. Despite the liquidity associated with US stocks and ETFs, traders need to measure liquidity to properly analyze the risk reward of a trading strategy.
Liquidity risk is the ability of a portfolio manager to unwind a position and generate possible profits in a timely and efficient manner. Historically, there have been a number of events in the recent past that have created the need to analyze the liquidity and transparency of a portfolio.
For example, in 2008, even the very liquid EUR/USD contracts, which allow traders to hedge Libor, were relatively illiquid, due to the financial crisis and the inability of banks to lend to one another. The volatility of the crucial product became so severe that money market funds priced below par.
Liquid products such as government bonds, large cap equities and currencies, have relatively tight bid offer spreads, which allow an investor to enter and exit a position without significant slippage. A bid-off spread is the difference between where market markers will purchase a financial instrument, which is called the bid, and where market makers will sell a financial product, which is called the offer. These types of markets are relatively transparent, and finding liquid price action is readily available.
Certain types of assets, such as real-estate or loans, are less liquid and are more opaque than liquid markets. Transactions on these types of assets can be few and far between, and the bid offer spread, may be very wide. During the peak of the housing crisis, which is still ongoing, there were times when there was no bid at any price for houses and apartment buildings.
Over the Counter Products
Non-liquid products are usually over the counter products which are traded under guidelines that are governed by the market participants themselves. For example, many financial instruments that are over the counter instruments are governed by ISDA, the International Swaps Dealers Association.
The guidelines give some semblance to the market environment. Products can range from interest rate swaps, which allow companies to hedge against specific interest rate exposures, to exotic options that are used to make sophisticated bets. Many of these type of products experience large bid offer spreads.
Most over the counter products are traded by market makers which are generally banks, investment banks, and large hedge funds. Each position within a portfolio has specific liquidity and a cost associated with it to turn it into cash. For example, a 5-year natural gas swap may have a larger bid/offer spread than shares of a large liquid currency pair such as the EUR/USD.
Liquidity risk is another form of risk that investors need to be aware of before they create a strategy that employs illiquid assets. Generally large cap stocks, and liquid currency pairs have tight bid offer spread, but as the size of a position increases, the slippage risks increases. As an example, a position of 10,000 shares would barely budge the spread in Apple Inc., shares, but a position of a million shares that were sold all at once, may have a negative effect on price action. Small cap stocks are usually susceptible to increased liquidity which is important to focus on prior to initiating a position.